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Crunch looms for banks’ high dividends

New rules will force major banks such as NAB to reintroduce discounted DRPs, which will pinch earnings per share.

Summary: Regulatory guidelines requiring Australian banks to hold more capital on their balance sheets for liquidity purposes have come into effect, and the major banks must hold an even higher level than other financial institutions given their status as Domestic Systemically Important Banks. In meeting these strict guidelines, some banks will be stretched to maintain their dividend payout ratios and will need to introduce dividend reinvestment program discounts.

Key take-out: Westpac appears to be the best positioned of the major banks on a capital level, followed by Commonwealth Bank, ANZ and National Australia Bank.

Key beneficiaries: General investors. Category: Shares.

The Australian major banks have enjoyed strong share price performance since 2012, having outperformed both the broader Australian market and most global peers in the last 12 months.

Their profitability has been resilient, having benefited from disciplined margin management, tight cost control initiatives and improving bad debt charges. With an environment of low credit growth and improving asset quality post the global financial crisis, the major banks have been increasing the amount of capital they return to investors via dividends. However, regulatory uncertainty appears to be rearing its head once again.

This article explores the regulatory changes under way and the sustainability of high dividend payout ratios for the major banks. It suggests that Westpac (WBC) is better positioned than its peers, in that it is the only major bank which has the ability to sustain its current payout ratio while still meeting new capital requirements. WBC is followed by Commonwealth Bank (CBA), ANZ and then National Australia Bank (NAB) in terms of positioning.

Origins of the Basel framework

While the adoption of the Basel II global banking guidelines coincided with the darkest depths of the GFC, the framework was actually introduced by the Basel Committee in June 2004, with most banks beginning work on ‘Basel projects’ at that point. One of the primary intentions of Basel II was to link capital requirements more closely to risk, allowing banks to model their risk (and hence capital allocation to certain loans) internally with a more sophisticated approach under the watch of the Australian Prudential Regulation Authority.

The initial impact on the banks over the period was more an operational one as banks sought to obtain ‘advanced accreditation’ from APRA, enhancing risk rating tools and building data gathering capabilities to comply with APRA’s requirements. As part of the application process for ‘advanced accreditation’, the major banks began calculating risk-weighted assets in accordance with Basel II in mid-2006. All the major banks met requirements for accreditation by the end of 2007.

However, as the ink was drying on Basel II, the Basel Committee released a consultation paper in December 2009 – and the major banks went back to work, launching new projects around Basel III. Under Basel III, APRA now requires the major banks to not only hold more capital but also a higher quality of capital. More specifically, the new regulations require the major banks to hold 7% Common Equity Tier 1 (CET1) capital, which is primarily funded by ordinary shareholders’ equity compared to the previous minimum of 4% Tier 1 capital, which could be in part funded through hybrids (eg. preference shares or convertible shares).

As illustrated in the chart below, the major banks aggregate Tier 1 ratio has increased from 7.2% in 2006 to 10.4% with a shift in the focus from Tier 1 capital to CET1 capital, a higher quality form of capital.

Impacts of a new regime

While more recently the major banks have increased their regulatory capital through organic generation given low bad debt charges and low credit growth, this was not the case during the GFC. In the initial stages of the GFC, the banks were faced with a period of high business credit growth (which is quite capital intensive), reduced profitability which was eroded by bad debt charges (thereby removing their ability to generate capital) and rising dividend payout ratios in the wake of falling earnings per share. As a consequence the banks were required to (1) cut dividends; (2) introduce dividend reinvestment program discounts to raise DRP participation; and (3) raise capital through fully underwritten DRPs, institutional placements and retail share purchase plans.

Initially ANZ and NAB were impacted hardest given higher bad debt charges (reducing their ability to organically generate capital) and, as a result, had to raise more capital than CBA and WBC. Accordingly, ANZ and NAB were slower in reducing DRP discounts and reintroducing buybacks to neutralise DRPs (see Figure 4). More recently, ANZ has been the most impacted by the introduction of Basel III given the punitive nature of Basel III on minority holdings and equity investments, which are of relevance to ANZ’s investments in Asia.

“Too Big To Fail”

In November 2011, the Basel Committee published the critical framework text “Global systemically important banks: Assessment methodology and the additional loss absorbency requirement”. This document announced the final methodology for determining Global Systemically Important Banks (G-SIBs), or “too big to fail” banks. As of November 2013, the Financial Stability Board (FSB) has named 29 G-SIBs that would be subject to higher capital requirements and greater oversight.

None of the Australian major banks appeared on the original list of 28 G-SIBs. These G-SIBs are required to adhere to higher minimum capital requirements from January 2016. However, the Basel Committee proposed giving flexibility to local regulators to broaden the framework to Domestic Systemically Important Banks (D-SIBs).

In December 2013, APRA announced that the major banks will also have to hold an additional buffer of 1% in CET1 capital after deeming them to be D-SIBs. This takes the minimum CET1 ratio to 8%. However, APRA provided some relief, stating that it would be reasonable for a D-SIB to operate with a relatively lower management capital buffer than before.

It is unlikely that a major bank would allow its CET1 ratio to fall below the 8% minimum as it would lead to APRA imposing progressive restrictions on dividend payments and bonuses. Therefore, it’s expected the major banks will operate with a buffer in place. Specifically, ANZ and NAB are likely to target a CET1 range of 8.75% to 9.25%, while CBA and WBC will target a CET1 range of 8.50% to 9%. This difference is predicated on the expectation that ANZ and NAB will maintain an additional buffer of 0.25% to account for their relative skew to business banking, given its relative capital intensity.

In need of more capital?

While the major banks are adequately capitalised to meet the required current minimum of 8%, none of the banks are currently above 9% (after adjusting for WBC’s acquisition of Lloyds Australia). The major banks may need to raise additional capital by either cutting dividend payout ratios or resuming DRP issuances.

We have benchmarked our estimates of each major bank’s CET1 ratio after factoring in the effect of the implied organic capital that each bank will generate in FY14E and FY15E. CBA’s organic capital generation stands out from peers as a result of its sector leading return on equity. Both WBC and CBA will be above an 8.50% target but not above a 9% target based purely on their underlying capital dynamics without factoring in any capital management initiatives. On the other hand, both ANZ and NAB fall short of our expected 8.75-9.25% target range.

The following chart illustrates the implied capital shortfalls against our estimated CET1 ratios for a number of various CET1 targets. This chart clearly shows that WBC is best positioned amongst peers prima facie at all target levels.

Implications for dividends

We have assessed the sustainability of the major banks’ current dividend payout ratio forecasts in the context of being able to achieve the mid-point of our target CET1 ranges. Currently, consensus has forecast for these payout ratios to be broadly flat in FY14E and FY15E. Based on our analysis below, only WBC is capable of maintaining its forecast payout ratio of 80% while also meeting the mid-point of our CET1 target range for WBC of 8.5-9%. All of the other three major banks would not be able to sustain their respective forecast payout ratios without resuming DRP issuances (at least for one half year), if they are to achieve the mid-point of their respective CET1 target ranges.

Given that major banks are generally quite unwilling to reduce their dividend payout ratios, we assume that they would instead resume DRP issuances to meet any capital shortfall they may face. With this in mind, Figure 10 illustrates the average annual level of DRP participation required for each bank in order to meet the mid-point of its target CET1 range and also the resulting EPS dilution. Our key findings are as follows:

ANZ would need to conduct DRP issuances for both FY14E and FY15E, but this would not be done at a discount as an annual participation rate of only 22% is required. Historically, this level of participation has been achieved without the need for a DRP discount.

CBA would need to cease DRP buybacks for one half but can then recommence on-market buybacks

NAB would need to conduct DRP issuances for both FY14E and FY15E at a 1.5% discount in order to attain a participation rate of 35% in each year. This would dilute EPS by 2.1%.

WBC would not need to resort to DRP issuances and can continue to conduct on-market buybacks. It is the only major bank which actually has capacity to increase its dividend payout ratio (without conducting DRP issuances), albeit marginally.

In other words, there is limited scope for the major banks to undertake further capital management initiatives in the future, although they are not all equally positioned. In our view WBC is best placed, followed by CBA, ANZ and then NAB.

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